Goldman Special Situation Profit Seen at Risk With Volcker

When Chairman and Chief Executive Officer Lloyd C. Blankfein, seen here last month, addressed investors at a conference on Nov. 11, 2008, less than two months after rival Lehman Brothers Holdings Inc.’s bankruptcy, he tried to reassure them about Goldman Sachs’s ability to make money. Photographer: Andrew Harrer/Bloomberg

March 28 (Bloomberg) -- For Goldman Sachs Group Inc.’s
Special Situations Group, disasters can be a source of some of
the biggest profits. Now the secretive investing operation faces
its own potential calamity.

Goldman Sachs already has shut two units that made bets
with the company’s money because such proprietary trading by
banks will be prohibited under the Volcker rule approved by
Congress last year. Still, the Special Situations Group, known
as SSG, continues to make investments and named a new global
head last month. Executives have argued that SSG shouldn’t be
affected because it’s more of a lending than a trading business.

Created during the late 1990s, SSG invests the bank’s money
in the debt and equity of troubled companies and makes loans to
high-risk borrowers. The effort to defend it illustrates how
important the business is to Goldman Sachs and may be a test of
how flexible regulators will be in defining proprietary trading.

“It is proprietary trading, but the business can also be
modified if you had to,” said Brad Hintz, an analyst at Sanford
C. Bernstein & Co. in New York. The question, he said, is
“Where will the regulators draw the line?”

While SSG’s financial results aren’t published, the unit
has been a major profit contributor at New York-based Goldman
Sachs -- the biggest in some periods -- according to former SSG
executives who asked not to be identified because they don’t
want to speak publicly about their former employer.

Twice the Profit

Investing and lending, the newly created Goldman Sachs
division that includes SSG, proprietary-trading businesses and
investments in hedge funds and private equity, generated 32
percent of the firm’s 2010 pretax profit, almost twice the
profit from investment banking and money management combined.
Only sales and trading contributed more. Until last quarter,
SSG’s results were included in Goldman Sachs’s largest segment
by revenue: fixed income, currencies and commodities, or FICC.

Richard M. Ruzika, 51, a former Goldman Sachs commodities-trading chief and one-time New York Jets recruit, is retiring
from the firm at the end of April after running SSG since 2007,
said a Feb. 17 memo obtained by Bloomberg News. He will be
replaced by Jason M. Brown, a Briton who has led SSG in Asia
since 2007, according to a separate memo. Brown, who joined
Goldman Sachs from Bear Stearns Cos. in 1999 and became a
partner in 2006, will remain in Hong Kong.

Japanese Golf Courses

The unit bought distressed assets in the aftermath of
Asia’s financial crisis and profited in the Enron Corp.
bankruptcy, one former employee said. A gain on an investment in
Accordia Golf Co., Japan’s largest golf-course operator,
contributed about $500 million to fixed-income’s $3.1 billion of
revenue in the fourth quarter of 2006. The gain wasn’t disclosed
by Goldman Sachs until a year later.

Without those profits, it would be difficult to generate
returns previously achieved, analysts said. Goldman Sachs’s
annualized return on average common shareholders’ equity was
13.1 percent in the fourth quarter of 2010, down from 41.5
percent in the same period in 2006, company reports show.

Goldman Sachs has dropped 6.1 percent this year to $157.97
on the New York Stock Exchange, compared with a 2.5 percent gain
for the 81-member Standard & Poor’s 500 Financials Index.

When Chairman and Chief Executive Officer Lloyd C.
Blankfein addressed investors at a conference on Nov. 11, 2008,
less than two months after rival Lehman Brothers Holdings Inc.’s
bankruptcy, he tried to reassure them about Goldman Sachs’s
ability to make money.

Volcker Restrictions

“We believe we have as strong a track record as anyone at
being a nimble investor in special or distressed situations,”
Blankfein, 56, said. “We can decide the extent to which the
firm itself will invest.”

The Volcker rule, championed by former Federal Reserve
Chairman Paul Volcker, 83, and included in the Dodd-Frank Act,
could change that. The provision aims to constrain banks that
receive government backing, such as deposit insurance and access
to Fed funds, from betting on investments that could produce
significant losses. It would also limit the amount of money
firms can invest in private equity and hedge funds.

The Financial Stability Oversight Council, made up of U.S.
regulators, released a study and recommendations Jan. 18 on how
to implement the Volcker rule. The Fed and other banking
regulators must put it into effect by October.

Unanswered Questions

There are unanswered questions that could leave an opening
for SSG, said analysts and legal experts, including Roberta
Karmel, a former member of the Securities and Exchange
Commission who now teaches at Brooklyn Law School in New York.
Can Goldman Sachs claim that purchasing debt makes the division
a lender rather than a trader? If the unit holds its investments
for months or years, do they cease to qualify as proprietary
trading because the firm isn’t seeking to “profit from near-term price movements,” as the FSOC guidelines say?

“These laws are too complicated, and they can find
loopholes,” said Karmel. “I don’t know how strictly the
regulators will be able to define proprietary trading.”

David A. Viniar, Goldman Sachs’s chief financial officer,
said on an Oct. 19 call with analysts that the Volcker rule
might not affect SSG because “the predominant part of that
business is actually a lending business, which we think is not
only OK under the rules but is actually something that’s
encouraged because it obviously helps the economy grow.”

Goldman Sachs executives don’t believe the company will be
barred from using its money for so-called principal investments
as long as they aren’t made through hedge funds or private-equity funds, Guy Moszkowski, an analyst at Bank of America
Corp. in New York, wrote in a March 21 note to investors.

‘Key Drivers’

“One of the key drivers of Asia earning has historically
been the ability to deploy the firm’s own capital in principal
investments,” Moszkowski wrote after meeting in Hong Kong with
four Goldman Sachs executives, including Yusuf Alireza, head of
securities for Asia. “GS continues to believe, based on its
interpretation of Volcker, that non-fund-related direct
investing will not be precluded.”

Many of those investments are likely to be made through SSG
or another unit called PIA, for Principal Investment Area,
Moszkowski said in a phone interview after the report.

“They have been in the past, and they will be in the
future,” said Moszkowski, who rates Goldman Sachs stock
“neutral.” “Historically these types of balance-sheet
investments have cropped up in many places around the firm, and
it’s never entirely obvious that that’s a PIA investment or
that’s an SSG investment.”

Troubled Companies

In his note, Moszkowski said it isn’t clear how Goldman
Sachs will defend SSG’s practice of making loans to troubled
companies and then receiving equity when the debt is converted
to stock in a bankruptcy.

“To maximize many of these positions, SSG has followed a
‘loan-to-control’ strategy, whereby distressed-debt positions
wind up as a controlling equity stake,” the analyst wrote.
“Our interpretation of this has been that flat-out equity
investments, or holding periods after a conversion to equity,
will be very limited.”

If Goldman Sachs succeeds in convincing U.S. regulators
that SSG doesn’t run afoul of the Volcker rule, new regulations
from the Basel Committee on Banking Supervision could increase
the amount of capital the firm has to set aside against
principal investments, Moszkowski and other analysts said.

Sbarro Debt

Few of SSG’s investments are public, making it difficult
for analysts and investors to know what the division is doing.

Special Situations Investing Group Inc., a legal entity
that holds debt investments made by SSG, was included among
creditors on a Jan. 5 forbearance agreement with lenders filed
by Sbarro Inc., a pizza chain owned by private-equity firm
MidOcean Partners. While Goldman Sachs didn’t appear among
creditors on two more recent agreements, including a March 3
filing, a person at the firm familiar with SSG’s investments
said the unit still owns Sbarro debt.

The bank wasn’t an original lender to Melville, New York-based Sbarro, which owns or franchises more than 1,000 fast-food
restaurants, according to two members of the lenders’ syndicate
who asked not to be identified because they weren’t authorized
to speak to the media. Neither Goldman Sachs nor Special
Situations Investing Group participated in a January 2007 loan
to Sbarro or a March 2009 loan, according to data compiled by
Bloomberg. SSG acquired the Sbarro debt in the secondary market
in early 2010, the person familiar with the investment said.

‘Financial Distress’

Michael DuVally, a spokesman for Goldman Sachs, said he
couldn’t comment on SSG’s investments.

Buying debt in the secondary market doesn’t sound like
lending to James D. Cox, a professor at Duke University School
of Law in Durham, North Carolina.

“I find it hard to think that they’re just like the corner
bank lending money to somebody in financial distress,” Cox
said. “This looks more like trading than it does any other
activity, and it ought to be subject to Volcker requirements.”

There is a lending business within SSG, Goldman Sachs
Specialty Lending, that “originates (or purchases) loans made
to middle-market borrowers that cannot sufficiently access the
market through traditional senior bank lenders,” according to a
description in an SEC filing made by a Goldman Sachs subsidiary.

Xoma Ltd., a Berkeley, California-based biopharmaceutical
company, received a $35 million loan from the unit in 2006
secured by royalty payments on three drugs, according to a Xoma
press release at the time. The interest rate was the six-month
London Interbank Offered Rate, or Libor, plus 5.25 percent. The
loan was amended in 2008, with Goldman Sachs providing another
$20 million and increasing the interest rate to 8.5 percent plus
either 3 percent or six-month Libor, whichever was greater.

Regulators’ Warnings

The company violated the loan covenants in the first
quarter of 2009, when regulators’ warnings about its psoriasis
drug Raptiva led it to be pulled from European Union, Canadian
and Australian markets. Xoma fully repaid Goldman Sachs in
September 2009 by issuing new common stock and using the
proceeds of its sale of a drug-royalty stream. The repayment
included $2.4 million of accrued interest and a $2.5 million
prepayment premium. The loan cost Xoma $12.4 million in interest
expense for 2007, 2008 and 2009.

While SSG has produced significant profits over the years,
it also contributed to some of the firm’s biggest losses during
the financial crisis.

A pro forma accounting the bank provided in January showed
that the investing and lending division, had it existed, would
have lost $13.5 billion in the 12 months through November 2008,
an amount exceeding the pretax earnings from fixed income and
equities trading. It was the sole business at Goldman Sachs that
reported losses that year. SSG accounted for only part of that,
according to a person familiar with the matter.

Viniar Comments

SSG is almost never mentioned in Goldman Sachs’s regulatory
filings or publications, and Viniar doesn’t talk about it on
quarterly conference calls with analysts unless asked.

He provided some insight into the meltdown of two SSG
investments on Dec. 16, 2008, in response to a query from Glenn
Schorr, then an analyst at UBS AG.

“Well, that’s a group that you talk about more than we
do,” Viniar, 55, said. “I won’t name them, but we made two
investments where the total investment size between the two was
$68 million. Those investments have a life-to-date profit after
the fourth quarter of in excess of $300 million. But in the
fourth quarter we had over $200 million of losses on those
investments.”

The unit is a relative newcomer compared with other
proprietary-trading divisions. Goldman Sachs Principal
Strategies, the equities-trading team shut last year in response
to the Volcker rule, grew out of the arbitrage trading business
overseen by the late Gustave Levy, the company’s leader from
1969 to 1976, and Robert E. Rubin, 72, a former co-chairman who
left the firm in 1993 and later became U.S. Treasury Secretary.

Debt-Trading Team

SSG, whose history was pieced together from interviews with
seven former Goldman Sachs employees, including three who worked
at SSG, traces its roots to the high-yield debt-trading team
that spawned hedge-fund superstar David Tepper, 53, who left
Goldman Sachs in 1992 to found Appaloosa Management LP, and the
asset- and mortgage-backed trading team built by the late
Michael P. Mortara.

While both of those desks traded on behalf of clients, they
also invested the firm’s money in what one former employee said
was known internally as a principal overlay.

An entirely proprietary credit-trading group that didn’t
interact with customers was started in December 1996 by Jonathan
Kolatch, who left in 1999 and now runs Redwood Capital
Management LLC in Englewood Cliffs, New Jersey.

‘Much Bigger Business’

“We were there at the beginning, but later on it morphed
into a much bigger business,” said Kolatch, whose unit had
about $400 million of investments at the time. “We invested a
fraction of the assets that SSG ultimately managed.”

When Kolatch left Goldman Sachs, his unit was taken over by
Edward Mule, a partner who previously worked in the mergers
department. The business was renamed Special Situations
Investing, or SSI.

Mule, 48, had been running the distressed-debt trading
business with Robert O’Shea, 46, who built the firm’s global
bank-loan business after joining in 1990 from Bear Stearns. They
also teamed up in 1996 to start what evolved into the specialty
lending business. O’Shea went on to become global head of the
high-yield business unit, which included SSI.

It was the 1997 Asian financial crisis that jumpstarted
Goldman Sachs’s distressed-investing business. Mule and Peter
Briger, who worked in the asset- and mortgage-backed debt
trading unit, visited Asia and determined the firm could profit
by buying pools of loans and assets dumped on the market after
currencies were devalued and prices fell.

Special Opportunities

Briger, 47, who moved to Hong Kong, and Mule, who stayed in
New York, teamed up to run an investing effort in the region,
spending $800 million of the firm’s money before raising $1.5
billion for an Asia special opportunities fund. The fund
included about $150 million of the company’s money, with the
rest coming from investors including Japan’s Norinchukin Bank,
Hawaiian landowner Bishop Estate and the government of
Singapore, former employees said.

Goldman Sachs went public in May 1999, providing the firm
with a permanent source of capital. The group headed by Briger
and Mule, known as the Asia Special Situations Group, decided
not to raise more third-party funds and to make future
investments with the company’s money, former employees said.

Thai Auto Loans

Asia SSG became the dominant distressed-assets investor in
Asia, generating profits by purchasing discounted Thai auto
loans and corporate debt. One investment in South Korean liquor
company Jinro Ltd. generated a profit of almost $1 billion,
former employees said.

Briger and Mule both left in 2001. Mark McGoldrick, 52, who
worked under them, was named to run the Asia business and later
moved to London to oversee a fledgling European SSG. In the
U.S., Mule’s SSI unit was led for one year by Stephen Golden and
James Shim before being taken over by Joseph “Jody” LaNasa.
Under LaNasa, who left in 2006 and started Serengeti Asset
Management LP, SSI grew from $300 million of capital invested to
$4.5 billion and produced an average return of about 20 percent,
according to a former employee.

In November 2003, Goldman Sachs combined the Asian and
European SSG businesses with the SSI unit and two other U.S.
businesses, creating a single Global Special Situations Group,
according to a memo at the time. Ralph Rosenberg, who had been
co-chief operating officer of Goldman Sachs’s real estate
principal-investing unit since 2000, was named to run the global
business with McGoldrick, the memo said.

$70 Million Bonus

By the time McGoldrick left in 2007 -- with the Wall Street
Journal later reporting he was miffed at receiving only $70
million for his bonus -- Rosenberg was also gone, replaced by
Stephen McGuinness. Ruzika became co-head with McGuinness and
then sole head when McGuinness joined Goldman Sachs Asset
Management in 2008. The U.S. operations are led by Albert F.
Dombrowski, who was elected partner in 2008, while the European
business is overseen by Julian Salisbury in London, who also
became a partner that year.

Former SSG employees, several of whom have left to start
investing businesses focused on the same types of distressed
opportunities SSG specializes in, say the group has fewer
employees and less capital and freedom than it had in the middle
of the last decade. Then, one former employee said, the global
SSG business employed about 150 people, including five partners,
and had about $25 billion of the firm’s capital invested.

SSG currently has about half the capital invested that it
had at its peak, according to a person familiar with the matter.

‘Skill Package’

Like alumni of Goldman Sachs’s proprietary-trading desks,
most of SSG’s former employees went on to found or work for
hedge funds or private-equity firms. Briger is co-chairman of
Fortress Investment Group LLC; O’Shea and Mule founded Silver
Point Capital LP, where they serve as chairman and CEO; and
McGoldrick started Mount Kellett Capital Management LP.

“Where they go tells you what their skill package is,
what’s in their tool kit, and that tool kit is going to be
pretty revealing in terms of what got rewarded at Goldman
Sachs,” said Duke’s Cox. “It doesn’t look like your staid
banker’s tool kit. It looks to me like a trader’s tool kit.”